Are all ETFs same for investment?

Generally whenever one mentions Exchange Traded Funds (ETFs), people assume it to be a replica of the index, which in Indian scenario means the replica of Sensex or Nifty. However, it may not always be true. There are ETFs which track the subset of the index or a particular sector (eg. Banks) or even a commodity (eg. Gold). This post will guide you to understand ETFs and how to choose one.

ETFs available for investments:

One can invest in any of the following ETFs (I have chosen only those ETFs which are more than one year old):

Schemes	Asset Size (Rs. Cr)	1 Yr Returns	3 Yr Returns	Expense Ratio
Nifty ETFs
Nifty BeES	400	21.3	5.7	0.5
ICICI Pru SPIcE Plan	1	19.7	5.5	0.8
Kotak Sensex ETF	21	20.0	n.a.	0.5
Nifty Junior ETFs
Nifty Junior BeES	185	34.1	13.0	0.5
Banks ETFs
Nifty Bank Benchmark	19	28.5	16.9	0.5
Bank BeES	39	29.3	19.0	0.5
Reliance Banking ETF	15	29.0	n.a.	0.35
Kotak PSU Bank ETF	16	38.1	n.a.	0.65
PSU Bank BeES	7	37.9	n.a.	0.75
Gold ETFs
UTI Gold Exchange Traded Fund	390	20.4	23.7	1.0
Reliance Gold ETF	321	23.2	n.a.	1.0
Gold BeES	1244	20.3	23.8	1.0
Kotak Gold ETF	167	20.3	23.7	1.0
Quantum Gold Fund	24	20.3	n.a.	1.0
SBI Gold Exchange Traded Fund	139	20.9	n.a.	1.7

n.a. - not available

Returns as of 22nd October 2010

When to invest in ETFs?

Equity ETFs are good in diversifying your investments, similar to mutual funds. However, they generally track the benchmark in which they invest and can not give superior returns as compared to the benchmark. Whereas, mutual funds are managed actively and in countries like India, are able to generate additional returns. Diversified equity mutual fund should ideally form one’s core equity holding and equity ETFs should supplement this investment. However, in case one is not comfortable in trusting fund manager’s performance, he can invest more in ETFs.

What to look for in ETFs before investing?

1. First you should determine the type of exposure you would like to have through ETFs. In case you want the exposure to index stocks, good way to invest will be through ETFs like NIFTY BeES. If you want exposure to mid cap stocks along with large cap stocks, you can invest in Nifty Junior BeES. Similarly, in case you want to invest in Gold, you can look at Gold ETFs.

2. Second thing you need to do is compare the ETF returns with the benchmark. Your reason for investment in ETF is to ensure that you get returns similar to benchmark return. Hence, you should be wary of ETFs which consistently is above or below benchmark by significant percentage (more than 1% in this case). Tabulated below is the comparison of Index ETFs with the Nifty benchmark which is 20.5% for 1 year and 5.6% for 3 years. You can notice that generally they track the benchmark which is a positive sign (i.e. their tracking error is low). 

Similar analysis for Gold ETFs.

3. Next thing to check is the fund size. Greater the fund size, more comfortable you should be. Nifty BeES has the fund size of Rs. 400 crores as against Rs. 21 crores for Kotak Sensex ETF.

4. Last thing to check is the annual expenses which the fund house incurs to generate returns. Lower the expenses, better the returns. Hence look out for ETFs with less expense ratio. Nifty BeES and Kotak Sensex ETF have expense ratio of 0.5% p.a. where as ICICI Pru SpicE Plan has expense ratio of 0.8% p.a.

Keep these points in mind and start investing in ETFs.  Bachhat prefers Nifty BeES for exposure to index stocks, Junior BeES for mid cap stocks and Gold BeES for investment in gold.

As usual, comments appreciated.

ETFs – More findings from the research

Continuing my yesterday’s post on ETFs – their impact on your investments?, the research paper of Jefrey Wurgler, Nomura Professor of Finance, NYU Stern School of Business “On the Economic Consequences of Index-linked Investing” has other findings which I would like to highlight in this post.

On ETFs he says that 

“…the increasing popularity of index-linked investing may well be reducing its ability to deliver its advertised benefits while at the same time increasing its broader economic costs.” 

One can estimate the size of such funds from the following. 

“Standard & Poor’s reports that as of this writing (July 2010) there is $3.5 trillion benchmarked to the S&P 500 alone, including $915 billion in explicit Index funds. ETFs now amount to $1 trillion across all asset classes and indices. Russell estimates that $3.9 trillion is currently benchmarked to its indices. This gets us quickly to about $8 trillion in easily countable products.”

No doubt as ETFs continued to get popular in countries like India, they will start making impact on index stocks and their returns.

It further states that the stock which gets included in the Index changes its return pattern 'magically' and 'quickly'.  It begins to move closely with its other constituent stocks and less closely with the rest of the market.  In statistical terms, its co-variance increases with index stocks, thus increasing its beta.  This affects various corporate investment and financing decisions taken by this particular company (Remember Capital Asset Pricing Model (CAPM) where beta of the stock is one of the inputs for calculation of Cost of Equity).

Another interesting finding of its impact on the performance of active fund managers.
  

“the popularity of indexing may not be simply a reflection of the fact that active managers are unable, on average, to beat the index – it may actually be contributing to their underperformance."

Finally ending with his conclusion

"Indices and index-based investing are innovations that are here to stay and have rightly become central to modern investing.  The consequences are here to stay as well.  Research on the magnitude of the economic distortions they cause is needed, as are suggestions how regulators and market structures might reduce them."

ETFs – their impact on your investments?

Exchange traded funds or ETFs, as they are popularly known as, is one of the vehicles to invest your money in equity markets.  Since they invest in benchmark index in the same proportion as its constituents, their performance is similar to the benchmark they track and they have low tracking error as well as low operating cost.  All this making them as one of the important avenues of investment.  They are hugely popular in the developed countries and are slowly catching up in countries like India. 

In India, many fund managers are able to give returns exceeding the returns generated by the index funds and hence investors correctly prefer mutual funds more than the index funds.  However, as capital market develops, becomes more efficient and it gets impossible for fund managers to gain above normal returns, ETFs will become one of the prime vehicles of investment.

In countries like US where funds are available cheap, exchange traded funds have started blossoming because they invest in the indexes of emerging markets and give better returns. Since large sums of money is invested in ETFs which flows in to the stocks of the index, it should be interesting to know how this affects the performance of individual stock and of capital market overall.

Jefrey Wurgler, Nomura Professor of Finance, NYU Stern School of Business has researched the Economic Consequences of Index-linked Investing in his NBER paper and has come out with interesting conclusions.  He says that “.. index-linked investing is distorting stock prices and risk-return tradeoffs, which in turn may be distorting the corporate investment and financing decisions, investor portfolio allocation decisions, fund manager skill assessments, and other choices and measures.  These effects may intensify as index-linked investing continues to grow in popularity.”

This conclusion is interesting in many ways.  As a particular stock forms part of an index, all the ETFs are required to buy that stock till its weightage in the index.  This pushes up the prices of that particular stock as it enters the index.  Conversely, if any stock is removed from the index, ETFs sell that stock leading to declining stock price.  Mr. Wurgler observes that “On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event, with the effect generally growing over time with index fund assets.  Stocks deleted from the index have tumbled by even more.”  Here the event being that particular stock included in the index.

Similarly, as the fund flow increases to ETFs, these funds buy the underlying stocks pushing up their prices and improving their returns which in turn attract more investments in ETFs (“return chasing feedback loop” as per Mr. Wurgler).

To conclude, ETFs are good investment vehicle, more particularly where capital markets are more efficient.  For countries like India, their importance will grow as the capital market becomes more efficient.  They can form small part of your equity portfolio with diversified equity mutual funds comprising larger portion.

As usual, comments appreciated.

Where do I invest my savings? [Part 2]

This is continuation of my earlier blog post on investment avenues for retail investor. You can read Part 1 of this post here.
  
7. Exchange Traded Funds or popularly known as ETFs are funds which invest in benchmark index in the same proportion as its constituents. Their performance is similar to the benchmark they track. Since the composition of ETF is similar to the benchmark, they have low tracking error (the difference between ETF’s return and the benchmark’s return) as compared to equity mutual funds and also have low operating cost. It is good investment alternative for those who are not able to choose between various mutual funds or who do not want to bear the risk of fund manager’s performance.

8. Mutual Funds: Whenever any financial advisor approaches retail investor to invest in mutual fund, the investors assumes it to be an equity investment. However, there are mutual funds which invest in debts, mutual fund which invest in equities and also mutual fund which invest in both debt and equity. The debt funds are further divided into short term, medium term or long term depending on their time horizon. Similarly, equity funds can be sector specific or index funds. Thus within mutual fund there are various alternatives available to suit the investment and risk profile of the investor. Moreover, due to various regulatory changes carried out in last one year, mutual funds are now more transparent and cheaper with elimination of loads and curtailment of asset management fees which can be charged by fund houses. An investment in mutual fund which is more than a year old also gets preferential tax treatment. They are easy to invest and liquidity is not a problem.

9. Gold: One should view investment in Gold as a hedge against inflation rather than as wealth-creation investment. It is a type of insurance which will protect you in case the entire financial market crashes. Hence it should form small part of one’s portfolio. 

Real estate (other than the home where ones resides) should also form part of investment avenues but at a later stage of life, once a fair amount of financial corpus gets accumulated. Equity investments should ideally be in the form of mutual funds or ETFs investments, unless one is expert in individual stock picking.

Your suggestions are welcome.